Collateralised loan obligation: what benefits do they offer investors?

In recent years, collateralised loan obligations (CLOs) have become increasingly common in financial markets. Their mix of above-average yield and potential for income has proved attractive in the past.  They are often misunderstood because the principles on which they operate, the benefits they can offer and the risks they entail are not always easy to understand. An in-depth study by Vontobel Asset Management attempts to shed light on their structure and relationship to ESG.

What are CLOs?

Collateralised Loan Obligations (CLOs) are debt instruments that back a group of loans, often senior secured loans or leveraged loans to companies. These securities are divided into tranches with different ratings and yields based on their position in the CLO's financial structure, from AAA (the most secure) to equity (the least secure). CLOs are part of the asset-backed securities (ABS) market, which includes securitised securities (financial securitisation designed to transform non-transferable financial instruments into other transferable financial instruments) such as residential mortgage-backed securities (RMBS), auto ABS (based on car loans) and credit card-based securities. However, CLOs differ from ABS in that they are backed by leveraged loans to businesses, not consumers, and cover a pan-European market that is diversified in terms of sectors and maturities.

What are leveraged loans?

Leveraged loans are at the core of CLOs and are essential for the payment of interest and principal to CLO investors. Leveraged loans in European CLOs are typically 'senior secured', meaning that they have the highest priority in the event of the borrower's default, making CLOs relatively low-risk investments in the non-investment grade corporate bond segment. A typical loan within a CLO is rated between BB+ and B-, has a maturity of approximately five to seven years and offers floating rate interest payments linked to Libor or Euribor.

The management of CLOs

Collateralised Loan Obligations (CLOs) are actively managed by an asset manager who builds a diversified portfolio of loans to companies of different sizes and geographical locations. The manager can buy and sell loans to maximise returns, but is bound by specific restrictions on the assets, their quality and their underlying characteristics. The loans are then transferred to a special purpose vehicle (SPV), which holds and manages them under the supervision of the CLO manager. The primary purpose of the SPV in European CLOs is to hold the assets and distribute interest and principal payments to investors. It is important to note that, unlike other types of asset-backed securities (ABS), CLOs do not expose creditors to the risk of corporate default and are considered safe investments.

The advantages of CLOs for investors

Investors who choose to include CLOs in their fixed income portfolios can benefit from a number of unique features of this asset class:

-CLOs can offer far greater flexibility than traditional corporate bonds, particularly in low yield environments and when seeking to enhance portfolio returns.

- The floating rate feature of the tranches reduces the investor's exposure to short-term interest rate risk, effectively providing a hedge against inflation.

- As a niche asset class, CLOs have historically commanded a significant spread premium over more traditional corporate bond markets.

- CLO holders also benefit from portfolio diversification as the asset class has a low correlation to investment grade credit and equity performance.

ESG integrated into CLOs

Growing client demand and regulatory developments are bringing environmental, social and governance (ESG) factors to the forefront of the collateralised loan obligation (CLO) market, although the process is still in its infancy. However, the trend is clear and managers are adapting their processes to incorporate these factors into investment decisions. The most common method used by CLO managers sensitive to ESG issues is the application of 'negative screening', which involves restricting investments in loans from companies operating in certain sectors, such as tobacco, arms production and fossil fuels.

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